It's tough out there for policymakers seeking to stabilise economies, and shocks from abroad aren't helping. This column argues that for countries hit by recession, fiscal stimulus in another country might significantly stimulate demand back at home, softening the worse effects of the current crisis. The evidence suggests that transnational coordination of fiscal policy may well be more valuable than previously thought.

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Policymakers seeking to stabilise the economy face many challenges. A recent set of challenges is shocks from abroad. Such shocks can come from many directions: trade channels as during the Great Trade Collapse of 2009; financial linkages as during the 2008 Global Crisis; and capital flows (Crucini et al. 2008). Foreign fiscal policy is one shock that has been especially prominent during the Eurozone crisis and the US fiscal cliff discussion. Indeed, a common justification for fiscal agreements like the Stability and Growth Pact and successive measures adopted by Eurozone countries is that, having relinquished independent monetary and exchange rate policies, individual countries need some protection from the shocks of uncoordinated fiscal policies.

Fiscal spillovers

Economic observers long appreciated the importance of fiscal spillovers. The current economic environment consists of ever-increasing globalisation and conflicting demands for fiscal austerity and fiscal stimuli. This calls for clear and robust evidence with which policymakers can navigate through the Great Recession and its aftermath. Specifically, there are at least three key questions to be addressed:

What is the effect of fiscal austerity/stimulus in one country on economic conditions in another?

Can countries short of fiscal ammunition (e.g. Greece) be supported by positive fiscal stimulus in other countries?

Does the strength of fiscal spillovers vary over the business cycle?

What should be the scope of coordinated fiscal policies in recession? Our recent research (Auerbach and Gorodnichenko 2012c) sheds new light on these questions, with results that have immediate policy implications.

Fiscal shocks

The key ingredient in our analysis is a measure of fiscal spillover shocks. Building on our earlier work (Auerbach and Gorodnichenko 2012a, 2012b), we construct these shocks as follows:

First, we compute real-time, one-period-ahead forecast errors for government spending in each country from the OECD’s "Outlook and Projections Database".

This step helps to purify the series from predictable changes in government spending.

Second, to further purify the series from predictable movements in government spending, we project the forecast error on that country’s lagged macroeconomic variables (output, government spending, exchange rate, inflation, investment, and imports) as well as a set of country- and period-fixed effects.

The residual from our regression captures innovations in government spending orthogonal to professional forecasts and lags of macroeconomic variables. We take this residual as a measure of unanticipated government spending shocks.

Third, to construct the fiscal spillover shock affecting a given country, we aggregate fiscal shocks across source countries with bilateral trade weights.

Thus, the strength of the fiscal spillover is affected by the intensity of trade between countries as well as the overall openness of countries to trade.

Empirical framework

To model the effects of fiscal spillovers, we extend our approach (Auerbach and Gorodnichenko 2012b) and use data for a panel of OECD countries to estimate fiscal spillover multipliers using direct projections. We can use the same approach to study the effects of fiscal spillovers on a number of other macroeconomic variables in addition to output, hence painting a more detailed picture of how fiscal shocks propagate across countries.

We also wish to allow the impact of shocks to vary over the business cycle, given the findings in our earlier work that multipliers vary over the cycle and are larger in recessions.

Results

We find that fiscal spillovers are significant in both statistical and economic terms.

Depending on the sample of countries and measures of fiscal spillover shocks, the average real GDP multiplier of fiscal spillovers over the three-year horizon window is between one and two.

These multipliers are larger than those we found previously for domestic government spending shocks. Given that our spillover shocks are scaled by the level of imports from the affected country, this result suggests that spillovers are stronger than would be implied simply by the level of trade.

Importantly, the effect varies tremendously over the business cycle, with spillovers being particularly high in recessions (between three and five) and quite modest in expansions (typically zero).

Transnational fiscal stimuli

In other words, if a recipient country is in a recession, a fiscal stimulus in another (source) country is likely to be particularly effective in stimulating demand in the recipient country. It is also possible that the spillover might depend on the source country’s economic conditions. For example, if a source country is in recession, a positive fiscal shock there might have a bigger local impact on output and on import demand, and therefore provide a bigger stimulus to recipient country production.

According to this logic, multipliers should be bigger if there is a recession in the source country as well as if there is one in the recipient country. We find that this logic is borne out by the data and indeed fiscal spillovers increase further when both recipient and source countries are in recession. This finding has immediate policy implications in the current economic environment, where economic activity is depressed in many countries. Specifically, as a fiscal stimulus in one depressed economy has a more positive effect on another depressed economy, these amplified fiscal spillovers increase the argument in favour of coordinated fiscal stimulus, to help internalise externalities from fiscal shocks.

We also estimate multipliers for a variety of other important macroeconomic aggregates. For example, fiscal spillover shocks have a strong, stimulating effect on exports in recessions, while in expansions the effect is negative. In contrast, imports have only weak, statistically insignificant responses to fiscal spillover shocks. These responses are consistent with the notion that trade can be an important channel of how fiscal shocks are propagated across countries. In general, the results confirm those in Auerbach and Gorodnichenko (2012b) where we estimate the effects of own-country fiscal shocks within the OECD, especially when one constrains the sample to large countries or pre-2008 observations. All components of output rise more in recession, as does employment.

Conclusions

In an increasingly globalised world, policies adopted in one country are ever more likely to affect economic outcomes in other countries. The extent to which one country’s fiscal policies spill over into others is a key question in the current environment with depressed economies and high or rising levels of public debt in many developed countries. We document that fiscal stimulus in one country is likely to have economically and statistically significant effects on output in other countries, and that the strength of spillovers vary with the state of the economy in recipient and source countries, with output multipliers being very large in recessions. These results suggest that fiscal activism may be effective in stimulating demand in economic downturns and that coordination of fiscal policies may be more valuable than previously thought.